Turn on the profit taps with these top water plays

Global demand for fresh water is surging, but supply is spluttering. And that means there's a great investment opportunity says Tim Bennett.

Demand is surging; supply is spluttering. That means there's a great investment opportunity in water, says Tim Bennett.

Every time you have a meal, a great investment opportunity is sitting right under your nose. Getting, say, a small, medium-rare steak to your dinner table, followed by an ice-cream dessert, takes around 6,500 litres of water, thanks to the involvement of water-intensive industries such as agriculture, energy, packaging and distribution. If you also have a glass of wine, add another 250 litres - and that's all before anyone washes up.

So what, you might ask? The trouble is, we don't have that much water to go round. A full 97% of the planet's supply is undrinkable seawater. Another 2% of our fresh water is locked up in glaciers and icecaps. So we rely heavily on a small amount of groundwater (about 0.6%) and what's left, which is scattered across lakes, rivers, soil and the atmosphere. And unlike, say, oil, there are no hidden reserves still to find. Yet the amount we use and waste just keeps growing. In short, as the Financial Times says, "water has never been under more threat in modern history".

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But when something's in short supply, that tends to create investment opportunities. It's not easy to invest in water directly it's not traded like a commodity, although some believe this is the best way to preserve it (see below). However, you can invest in the firms that are helping us make the most efficient use of the water we have. The good news is that, due to the financial turmoil, some are now available much more cheaply than they were a year or so ago.

The demand deluge

We are used to consuming vast quantities of water for everything from cleaning our teeth (an average eight litres per scrub if you leave the tap running), to gardening Americans sprinkle around seven billion gallons on their lawns every day. Then there's industrial use. Energy production is highly water intensive it can take over 3,000 litres to generate one megawatt-hour of electricity.

This will only get worse as our easily accessed oil reserves start to run out. Extracting a single barrel of oil from oil sands, for example, uses up 750 litres. In Colorado, Shell and ExxonMobil's oil production targets will require more water than the whole of the Denver city area's annual consumption, says Discovery magazine. No wonder oil firms have raced to secure water rights to more than 656 billion gallons enough to quench Denver's thirst for three years.

Then there's agriculture. One kilo of beef uses around 13,000 litres of water to grow the crops needed to feed a cow, water it, then process its meat. But now that emerging-market consumers are more affluent and less inclined to subsist on rice and vegetables, the pressure on water supplies is growing. The World Water Council reckons that, over the past 100 years, Earth's population has tripled, but our combined domestic, industrial and agricultural demand for water has risen six-fold. Looking ahead to 2050, an extra three billion mouths will need 50% more water than we use now, says the Stockholm International Water Institute.

Supply is spluttering

That might not matter if supply was located where we need it. But it isn't. China, for example, has around a fifth of the world's population, but only 7% of its water supplies, reports Forbes. As such, says Investment U, two-thirds of China's population already face regular water shortages. And huge damage is being done by the contamination wrought by fast-track industrialisation and urbanisation.

No wonder Beijing is involved in a vast overseas African land grab it doesn't just want the land, but also water, or the rights to it. The International Food Policy Research Institute reckons an area of Africa the size of France is under negotiation with various foreign powers. For Middle Eastern countries such as Saudi Arabia, it's cheaper to buy Africa's water rights and land than to grow crops at home. These countries say they'll repay Africa with infrastructure aid, but many observers are sceptical as to whether Africa is getting a fair deal.

The situation is being made worse by the fact that food importers are increasingly unable to rely on the world's big 'virtual water' exporters Australia and America. 'Virtual water' is a phrase used to describe the fact that a large chunk of all the crops and livestock consumed around the world are produced by a handful of countries, such as Australia and the US. These producers are known as 'virtual water exporters', as it's their water and land that produces the food sold overseas. But recent floods and droughts have put paid to around half of Australia's total virtual water exports.

Profit from leaky pipes

Sheer waste in developed economies is also a problem. As Garry White notes in The Daily Telegraph, "the US is facing one of the most serious water problems of any developed nation because it has overstretched itself". For example, the water level in the largest US reservoir, Lake Mead, is 100 feet lower than it was nine years ago. US water infrastructure is in dire need of upgrading or replacing to prevent huge leakage and wastage.

"America is soon going to have to face the fact; its infrastructure is old," says Chris Mayer in The Daily Reckoning.

As the American Society of Civil Engineers (ASCE) notes, "drinking water faces an annual shortfall of at least $11bn to replace ageing facilities and to comply with future federal regulations". And that takes no account of growing demand for water over the next 20 years. Estimates for the total investment needed over that period vary from $335bn, if you ask the Environmental Protection Agency (EPA), to more than $1trn if you quiz the ASCE.

So the $6bn earmarked so far in the federal stimulus legislation for water projects is peanuts.

About two-thirds of future investment will go on new pipes to replace old underground ones supplying businesses and homes. As The New York Times points out, in parts of South Dakota, Alaska and Pennsylvania, these worn-out pipes are not even made of cast-iron, but of wood.

No wonder the EPA estimates there are around 240,000 water main breaks each year across the US. As the mayor of Warren, Michigan, put it after his city suffered 107 pipe breaks in a single month this year: "We have this ticking time bomb that's ready to go off... what lies beneath is as dangerous as what's above."

That problem is made worse by the fact that newer isn't always better. South Dakota's ancient wooden pipes still just about function. But the oldest cast-iron pipes, dating from the late 1800s, have an average useful life of about 120 years, says the American Water Works Association. For cast-iron pipes from the 1920s that drops to about 100 years; anything from after World War II might last 75 years. So America faces having to replace three separate vintages in a very short space of time.

All of this is good news for Northwest Pipe (NASDAQ: NWPX), which makes high-pressure steel pipes. The share price is down 22% this year, and is around half of its peak 2008 price. The current p/e is ten and the forward p/e 19, but a price/book (p/b) ratio of just over one compares well with recent years. Gearing (total debt to equity) is a modest 40% and interest cover a healthy eight times.

Another defensive play with exposure to water (mainly the manufacture of pumps and water control systems), plus defence and data storage, is ITT Industries (NYSE: ITT). This Fortune 500 stock with annual sales of $11bn is still growing 2008 earnings per share (EPS) were 14% higher in 2008 than 2007. The forward p/e is 12 with a price/earnings growth (PEG) ratio of 0.99 and an expected dividend yield just below 2%. Again, gearing is modest at 41%, with interest covered around ten times.

China has infrastructure problems too: it hasn't got enough. Unlike America, many parts of China are starting from scratch when it comes to water infrastructure. The New York Times estimates that Chinese industries use three to ten times more water (depending on the product) than their US peers. That's scary, given that the EPA estimates an American firm uses 40,000 gallons of water to make a car and 60,000 per ton of steel. And Beijing is now pouring stimulus money into paying for upgraded and brand new infrastructure to cope.

One group that should benefit is Watts Water Technologies (NYSE: WTS), says Investment U. The firm has been operating in China since 1995 and owns several large factories there its valves, for example, have been used in the vast Three Gorges Dam. But Watts is also a solid defensive, due to its diversification. It has bought 48 global firms since 1987.

Outside China, where it is still fairly small, Watts is well established in the water fixture market. The stock trades on a forward p/e of 18 and yields 2.26%. For a more China-focused play, try water treatment and purification group Hyflux (Singapore: HYF), on a p/e of 18 and a yield of 1.8%. Hyflux is also a play on desalination (see below), and has recently won an order from Libya.

Save water increase efficiency

Infrastructure helps us get water from where it is to where it's needed, but given that the overall stock of fresh water is fixed, firms that can improve the efficiency with which it's used are also good bets. Here are seven decent plays on the theme.

Since irrigation "uses the majority of the planet's clean water", David Bogoslaw in BusinessWeek tips irrigation equipment firms Lindsay (NYSE: LNN) and Valmont Industries (NYSE: VMI). Of the two, Valmont looks better value to us. As well as improving irrigation efficiency, the firm designs and produces a broad range of other industrial and communications products. A forward p/e of 14 (compared to Lindsay's 28) and a PEG ratio of 0.94 are both reasonable and interest is covered a healthy 12 times.

Water filtering and recycling is big business both for consumers and businesses. As such, Calgon Carbon (NYSE: CCC) "is uniquely placed to benefit". It supplies the activated carbon used to treat water in sink filters, refrigerator ice-makers and water treatment plants. The forward p/e is 21 with a PEG of 0.81. Although the p/b ratio isn't rock bottom at 2.7, it is around 30% lower than last year. Gearing is low and interest is covered 13 times. One of our old favourites, Amiad Filtration (Aim: AFS), is also worth watching on a forward p/e of 13. The p/b ratio of 1.8 times is around half the level of a year ago, making the stock better value. Amiad supplies filtration systems and irrigation solutions to around 60 countries and offers a yield of 3.25%.

The credit crunch has hit the Middle East hard, with property prices diving in once-hot spots such as Dubai, and Western firms reporting trouble getting cash from clients. But the region is also a huge spender on water infrastructure and technology. So now looks a good time to look at stocks such as WS Atkins (LSE: ATK), says Jon Mainwaring in Investors Chronicle. The firm is one of the world's top engineering consultancies and is involved in the design and distribution of wastewater treatment and sewerage, plus coastal and flood defences. The dividend yield is 4.3% and the forward p/e is just under nine with a price/free cash flow ratio of around five.

A riskier play is Hyder Consulting (LSE: HYC), which provides technical know-how to a range of industries, with water accounting for about 20% of revenues. Clients are spread across Britain, Abu Dhabi and Oman. Yielding 2.3%, the forward p/e is just five. The p/b ratio is 0.95 and the price to free cash flow ratio a lowly 3.7. Margins have been under pressure and costs are being cut. But at the current price, returns could be hefty once the global economy recovers.

Lastly, there's Tetra Tech (NASDAQ: TTEK). This firm specialises in using 'biological membrane reactors' to remove water pollutants. The firm reported solid second-quarter results with revenue up 13.2%. The stock trades on a p/e of ten with a PEG of 0.65. Gearing is 44%, with interest covered 5.5 times.

Broader liquid plays

Exchange-traded funds offer cheap diversified water exposure. The Powershares Water Resources fund (NYSE: PHO) comes with an expense ratio of just 0.7%. It tracks the Palisades water index, so you get a heavy weighting to big US water players and exposure to just six countries. For a less US-focused fund, covering 16 countries with a big weighting to the US, France, Japan and Britain, there's Claymore S&P Global Water Index Fund (NYSE: CGW). It has an expense ratio of 0.7%, aims to tract the S&P 500 Global Water Index and is more of a pure water play than Powershares. Current top holdings are environmental services groups Veolia and Kurita Water Industries (see below) and British utility group United Utilities.

Two potential answers to the water crisis

Water trading

Putting a price on water may seem unethical (and impractical water is heavy, bulky and hard to transport). But as Jim Rogers, a fan of the idea, says: "When something's free, people use it. When it's priced, people use less or find more, which they can then bring to market. Simple economics."

A system is being tried in several Australian states, including Queensland and Victoria, where water entitlements are well defined and set out on a Water Allocations Register (similar to a Land Register for property ownership).

These allocations can be sold permanently, or for a single season, or leased out for a fixed period. The price is set by buyers and sellers. In Victoria, buy and sell orders are submitted, then matched by the central broker, Watermove, which charges the two parties a fee. There's no way for an investor to play the market directly and one of the few hedge funds involved Sextant Asset Management is being investigated by the Canadian financial regulator, but it's a space worth watching.

Creating water from water

Seen from space, the planet looks awash. But it's mostly seawater, no good for drinking or washing. Removing the salt is the obvious answer, but it's hard to do. The process is energy intensive (which makes it self-defeating, given energy production uses water) and produces a toxic brine that needs to be disposed of. This makes desalination expensive, although that's been no barrier for the oil-rich Gulf States around two-thirds of their water is produced this way. California has also invested heavily in desalination, although its budget woes may constrain future spending.

Desalination is also hard to invest in. One of the biggest players, liked by Kiplinger, is Japan's Kurita Water Industries (Tokyo: 6370), which derives around $2bn of its annual revenues from water, including desalination. But on a forward p/e of 30, it isn't cheap. Kiplinger also likes small, risky, but fast growing Energy Recovery (NASDAQ: ERII), which makes products that save energy during desalination, but the forward p/e is a toppy 35. For now, this is an area to watch rather than invest in.

This article was originally published in MoneyWeek magazine issue number 446 and was available exclusively to magazine subscribers. To ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.